With the advertising blitz coming from the upcoming Windows 8 launch, we had to consider adding Microsoft (MSFT) to our portfolio. Windows 8 is touted by many as the reason Intel (INTC) and AMD (AMD) should look forward to this quarter. Previously, we were of the same belief. Looking at the Surface RT advert, we came to the reverse conclusion. Thus we sold our Intel and AMD position, since there are no short term catalysts. This would also explain the surprisingly dismal year end outlook given by Intel in its latest report. Microsoft may be going on a limb to decimate Intel sales with the Surface RT, which is due to be launched on the 26th of October 2012.
First of all, the rather tasteful Surface Movement advertisement actually makes Surface RT appear very desirable, unlike some of the UltraBook adverts. Though it targets youth, we see an even bigger market. Microsoft here is not just adding support for ARM instruction sets and giving away a full copy of Office 2013, albeit the Home version. The product itself is interesting. It has double the storage capacity of the iPad, and 2GB Ram instead of 1GB, while being at the same price. Although it has a lower resolution, it will be hard to see the difference for most people. It includes 2 full sized USB ports, a very slim profile, an 8-hour battery life and an Nvidia (NVDA) Tegra 3 ARM application processor. The Tegra is not named directly in the official specifications, so that may change. Many analysts have been arguing that Microsoft should not try to copy Apple (AAPL) because it is a software company first. A cursory look at the Surface RT, Windows shop, and the marketing seems to indicate Microsoft is doing exactly that - taking a page from the Apple book. Surprisingly, the pre-order interest is strong. The base model has already sold out, on pre-order, in the US.
From an Microsoft investor point of view, there are important issues with the release of Surface RT, since it is built and branded by Microsoft and not OEM partners. This can threaten Microsoft's revenue from OEMs, if they turn to Android or Linux to lower their costs. We will leave the impact on Microsoft for another discussion. We are interested on the impact in the x86 market. The Surface RT looks, feels and plays very much like the iPad. But it is a lot better at editing, assuming Office 2013 for RT is as fully featured, as advertised. The brochure also seams to copy Apple's marketing style. Normally, "copy cat" plans do not work well because they lack innovation. Microsoft's plan may actually work because of the added value. Let us explain why.
The Surface addresses overlooked needs
Examine this case. I have an educated mother who uses a computer mainly for internet, email, video conferencing, Microsoft Office, and playing videos. She is looking for a new laptop, as her old one is on its last legs. Her friends, many of them, have iPads and bring them to her book club. Naturally, in her upgrade plans, she inquired if an iPad could be useful for her. I told her yes, you can do everything you need with it, except for editing Office documents. The editors on the iPad are not good, and do not work with complex formatted Word documents. She insisted she needs PowerPoint as well. My recommendation was to stick with a PC laptop. I said "You will get much more, for a cheaper price." So she is waiting until her laptop dies to get a new one.
Originally, we dismissed ARM based Windows 8 RT for her purposes. The troubling fact is that the Surface RT does exactly what my mother needs a laptop for. It is cheaper than the Intel-based Surface Pro, and it comes with Office for free. In addition, compared to a standard laptop, it is cool enough to turn heads at her book club. And this may be Intel's and AMD's undoing, to the advantage of Nvidia and ARM. A significant number of consumer laptops are being sold primarily for data consumption and some minor editing work. This market is large enough that it should worry x86 investors. Yet, this need is not currently being served by the iPad. The Surface Pro, on the other hand, is liable to replace laptop sales, rather than add to them, and so it may not provide the hoped for growth in Intel sales.
Windows RT impact on revenue
As argued above, with our use-case, there will be impact to the traditional x86 PC market. Let us quantify the impact. Microsoft has allocated about 5 million Surface RT units for sale this year. Projecting production and sales to next year along with OEM manufacturers, such as Lenovo's and Asus's announced Windows RT tablets, a conservative figure could be 15-20 million Windows RT tablets, shipped in 2013. Last quarter, Apple sold nearly 20 million iPads, and they don't nearly do as much as a Surface RT, so our assumption for the whole year is not unrealistic. These tablets could replace many x86 laptop upgrades, such as in my mother's use case.
Let's look at how this could impact worldwide revenue for the chipmakers (Windows RT, after all, is being marketed worldwide). Assuming just 20 million shipped Surface and OEM Windows RT units next year, that could reduce the projected 256 million notebook demand (see IDC report) to 236 million for x86 notebooks. A drop of 7.8% in notebook demand. Let's assume the drop is across the board with equal impact to Intel and AMD. In reality, it could just impact low spec notebook demand. For the sake of a worst case scenario we reuse the model from our previous analysis.
Notebooks are approximately 35% of Intel's revenue, and 26% of AMD's revenue. Thus, a 7.8% drop in notebook demand could mean a 2.5% drop in total revenue for Intel, and a 1.88% drop for AMD. To be fair, the Surface Pro will use Intel i5 CPUs. If every Surface Pro does not replace a laptop purchase, and Microsoft grows the market by 1 million units, the net impact to Intel revenue could be halved due to higher margin. We can expect a total of 1.25% revenue drop for Intel and a 1.88% revenue drop for AMD, directly as a result of Windows RT. One can use a DCF model like the one presented before to get share price impact. According to that model (see below), it implies an Intel share price of $18-$20, and an AMD price of less than $2. This is a realist "worst case" scenario with the implicit assumption that the hit will continue indefinitely. We are ignoring other threats and growth opportunities; if things stay as they are, Intel and AMD investors could be in trouble. The upside for investors in x86, is if Windows RT flops, as some predict, due to performance or other incompatibility issues.
Otherwise, the only reason to hold x86 manufacturers, is if you believe that they will grow in new areas over the longer term. AMD could grow in custom x86 processors, like the designs it has already won for next generation consoles. Intel can grow with smartphone Atom chips.
x86 investors should be cautious
The Intel x86 PC client base has dropped by at least one unit. The long term potential growth prospects, highlighted in other articles, still remain for both AMD and Intel. However we do not see any short term catalysts. Next week I will be buying my mother a Surface RT as a gift, if the reviews concur with the advertised hype. In her use-case the iPad-Mini and the Nexus are not viable alternatives. If it matches the hype, the Surface RT will be a formidable force. We are unsure how much Microsoft will benefit from this in the near term. However, what is certain is that this cash generating corporation is making the PC market less x86 centric. Will it also be the first product that haunts Apple? Only time will tell.
Additional disclosure: Thanks to T. Tasuji for editing an early draft of this article.